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I thought I would write a weekend blog regarding closing costs. We are heading into a refinance boom so many readers are going to be refinancing and many readers are going to ask, should I or should I not pay closing costs? It does not matter what lender or what loan originator you use, when you refinance a home or purchase a home there are closing costs. For example, your credit must be run so the lender can quote you the interest rate you qualify for. When your credit is pulled, it costs money. You will have to have an appraisal done on your home, and it costs money. You will more then likely close at a title office, and they expect to be paid for the service they provide. You may see ads that state no costs or free refinance. Some lenders, including myself, have done refinances where the client didn’t pay for the closing costs. This is referred to as a no cost refinance. There are costs, but what it actually means is someone else is paying the costs for you. I will explain this below.

Anybody you use to complete your refinance has to make money. I feel most consumers know this and want their loan originator to make a living and there are 2 ways that we get paid. You can pay us or the lender pays us in the form of yield spread premium. I get emails all the time saying I got whatever rate with no points. Every time I see that I think, how much lower of a rate would you have received if you paid a point? When we get a rate sheet from a lender, it has a range of rates not just one rate. Lenders offer what is called a par interest rate which means at that rate the lender does not compensate the loan originator. So, for the loan originator to make money and give their client the par interest rate, they must charge the client origination, points or a set fee. The loan originator can also give their client a higher interest rate then par, and the lender compensates the loan originator with yield spread, since the loan originator placed the client into a loan with a higher interest rate which will allow the lender to make more money in interest over the life of the loan. This method is how loan originators make money without charging points or a set fee. So, for a consumer to get a par interest rate, that consumer must pay all the costs associated with the loan and they must compensate the loan originator for the work they do. As a general rule, if you are planning on staying in your home for more then 3 years and since interest rates are at historic lows, it makes much more since for consumers to pay the closing costs and to pay the loan originator so they can get the best rate. Over time, the lower interest rate will offset the total costs

Now, let’s say a consumer is only planning on staying in their home for another year. Would it really make sense for them to pay several thousand dollars in closing costs for a lower interest rate since they will only be in the home for a year? No. In a case like that, the consumer can elect to take a higher interest rate. At a higher interest rate, the lender will pay the loan originator who in turn can pay the closing costs for the client and still make their profit. It’s not that the closing costs went away, it’s the closing costs where paid by the loan originator from the money they are paid by the lender for giving the client a higher rate of interest. As another general rule, if you are planning on staying in your home for less then 3 years a no cost or low cost loan with a higher rate is a better option. A low cost loan would be a loan where the client paid the costs but no points.

I do find quite often that the consumer cannot see the forest for the trees. Everyone has heard that quote before and I feel it is very relevant to this blog. Why should I pay $4000 in closing costs to get a lower rate? Well, lets say you have a loan balance of $150,000 and a rate of 6%. If you refinance, and lets say reduce the rate to 5% and it costs $4000, does it make sense to refinance? Well, a 1% lower interest rate on this loan size will save the consumer about $100 per month. If it costs $4000 and they are saving $100 per month, they recouped the closing costs in under 40 months. If this consumer is keeping the home for longer then 40 months, it was a good move to pay the costs to get the lower rate. Some people might point out that if this consumer refinances they are going back to a new 30 year loan. This is true, so lets say the client has had current loan for 2 year so they would have 28 more years to pay off the mortgage at the current rate and payment. If they refinance to the lower rate but they keep making the same payment, they would pay off the home in 23.5 years thus saving them 4.5 years of payments. So, what makes more sense to make the same payment for 28 years or 23.5 years?

If you are shopping for a mortgage and you are quoted a rate with no costs ask the loan originator how much lower your rate will be if you pay closing costs and origination. You will see that you will be offered a lower rate, then take what it costs divide it by the monthly savings to determine a break even point. If you plan to keep the home for longer then the break even point then it makes sense to pay the costs.

I hope this helps everyone reading to determine the most optimal mortgage for you and your family.

Comments

Victor,
Great post, with all the smoke and mirrors out there with advertising this was timely. I would also comment that with the current market at the spreads for ysp being very low that in todays market it makes more sense than ever to pay points.

On the second to last sentence in the first paragragh you write "There are costs, but what it actually means is someone else is paying the costs for you." In reality it should say "There are cost, but what it really means you are payingthem through a higher interest rate." or "There are cost, but what it actually means you are oaying for them over the time you hold this loan." There is no such thing as a "No Cost" loan. You pay it one way or another it is just what is the best for you to decide. In California the Dept of RE forbids the term "No Cost" in advertisements. Yet if licensed through Dept of Corp or work with a bank you can use the term no cost. The balance of the article is very good

Mike/Victor: In your comments regarding points, are you referring to discount points or origination points? I'm set to close on a refi first week of Jan, locked at 5.1 on 30-yr with no discount points. We plan on staying in our current home at the least five years but likely staying long term. I'm wondering if paying extra for a discount point to lower my rate is worth considering.

Victor - Isn't there an argument for taking a "no cost" rate if you believe it's fairly likely that rates are going to decrease further at some point in the future...allowing for a chance to refinance again down the road?
You may say then why not just wait for the (hopefully) lower rates and then pay closing costs and perhaps points as make sense depending on the time one is expecting to stay in the home. But let's say there are compelling reasons to take the proverbial bird in the hand...such as the existence of a current loan that has a (low) fixed rate for only fixed for a few more years...with a longer horizon to stay in the home.

Getting the rock bottom rate is also benefiting the borrower by lowering the monthly income. Especially on Jumbo loans- the difference in a 6% to a 5% could be around $400 a month and almost $1000 worth of income so as long as self employed stated income is not around these creative moves should help qualify the borrower.
Bill Black CMP
www.aofdowntown.com
Vancouver, Wa. Lending Professional

Chuck, you are absolutely correct, if you believe rates are moving lower. Today, rates are at historic lows, and yes they will be lower next year but not 2% lower then todays rates. In todays environment, it makes even more sense to buy the lowest rate available.

As a general rule of thumb it will take you approximately 52 months to break even if you can reduce your rate by an eight for half a point. This considers that you could earn about 3% interest on that money if you didn't spend it to reduce the rate.

Mike, you and I are on the same page with the low spreads between ysp's. I am telling my clients that paying closing costs and "buying down" their rate is currently "on sale". That means that you get more for your money when paying the closing costs yourselves than you traditionally would have.

Thanks for a great column that I can share with my borrowers. I try to explain but you did it so through.
Thank you,
Jharvill@amerisave.com
Best Rates or we pay you $500
We need loan originators!! www.kayharvill.com / go to "about us" ; make up to 88% commission; great company; average refinances 4-10 a week!!!

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